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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

GE Does Not Bring Good Things For Your Life

When is a stock safe enough to buy when it becomes difficult for corporations to find financing? We can answer the question two ways: 1) Why should we buy stocks when the financial markets are choking? Better to sit on cash. 2) We can’t tell when the turn is coming, so if we buy companies that are cheap with strong balance sheets and free cash flow, we should do okay over the intermediate-to-long run.

I’m going to illustrate this with a single stock tonight: General Electric. Why GE? Here’s something I haven’t mentioned recently about how I source stock ideas. I read widely, and when some one tells me a stock is cheap, I write it down for later analysis. My initial cursory analysis during this time of credit stress looks like this:

Let’s look at earnings estimates:

Yeah, is does look cheap. How has it done recently relative to expectations?

Mmmm…. not so good. Looks like they are still working off all of the bad accruals from the Jack Welch era.

Now, let’s look at the balance sheet:

Mmmm… there are a lot of intangibles on the balance sheet. Taqngible book value is light. Perhaps the intangibles have real economic value. If so, I would expect to see additional earnings over operating cash flow, and the is not there. Let’s look at debt maturities, could there be a call on cash?

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That doesn’t look good. What if we look at only the holding company?

Okay, not so bad. Most of the debt is from the finance subsidiary that I have argued for years should spun off. In a pinch, what are the odds that they would send GE Capital into insolvency? Very low, so I worry about the refinance risk. Will GE Capital get attractive financing terms over the next several years?

On to cash flows. Here are the cash flow screens:

Okay, free cash flow is positive, and congruent with earnings over the last five years. That’s a good sign. What else is there to look at?

holding-company-only.gif

Okay, Price-to-sales indicates that GE could be cheap versus their long history, but it could get cheaper.

Let’s look at summary statistics:

From all of the above, as I look at GE, there is a refinancing problem. Many debts come due over the next 5-10 years, probably matched by debt repaqyments over the same horizon. The effect of default from these repayments could be significant. I doubt that GE would be willing to send its finance subsidiary into insolvency.

In conclusion, even at the low levels that GE stock price has reached, I’m not comfortable with it. GE will have to refinance a lot of its debt over the next five years, unless they sell or default on GE Capital. The debt load outweighs the seeming cheapness.

Full disclosure: no position

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About David Merkel

David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does — on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor’s and master’s degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth. View all posts by David Merkel →